Price risk management tools embedded into physical trade

There are many ways to embed price risk management into physical trading contracts. As an illustration, in the United States Cargill offers 19 different pricing formulas to cereal growers and elevators.32 Contracts can include clauses guaranteeing floor prices, price increase sharing agreements, etc.. The major advantage of this from the producer’s perspective is that his buyer will take care of margin deposits, margin calls, execution of transactions and administration; also, the credit risk aspect of risk management can be dealt with as part of the underlying physical contract. The major disadvantage is that the cost of the risk management component is not transparent.

The principal way of incorporating a risk management instrument in a physical contract is the fixed-price forward contract, which specifies delivery of certain quantities at certain times, at a fixed price. The buyer (who may have to resell the coffee after delivery has been made) is likely to manage his price risk on the futures market. The seller thus has indirect access, without having to deal with any of the practical issues involved in dealing with an organized commodity exchange. Note that forward contracts do not eliminate price risk: if the producer is unable to deliver and market prices have fallen, the producer will be asked to make a compensatory payment.

Much used in the coffee market (although generally not reaching down to farmers) is another form of forward contract, the so-called price-to-be-fixed (PTBF) contract. This is a forward contract, specifying delivery of fixed quantities during one or more periods in the future, and using a futures market price as a reference. Until delivery takes place, the seller can fix the price at his convenience. From the seller’s perspective, a PTBF contract gives him access to the futures market without having to pay margins or margin calls. How the seller uses this access—for risk management or for speculation—is his decision.

It is also possible to embed options into physical contracts, e.g., in the form of minimum- price forward contracts. This would seem ideal from the seller’s point of view: he gets price insurance, is able to benefit from price improvements, and does not have to make any upfront premium payments. However, one would need to ensure that the implicit pricing of the options is not exorbitant.

Price risk management incorporated into finance

Banks can insist that as part of their loan package, the producer engages in a parallel risk management program, with the bank having control over the related bank and brokerage accounts. Alternatively, banks could manage price risks themselves, and pass on the effects in commodity-price indexed loans.

Commodity loans specify the repayment of principal and/or interest as linked to commodity prices, either in a direct manner, or as an option. They have been mostly used in the gold sector, but their use for coffee is feasible (in the early 1980s, a cotton plantation in Zimbabwe was financed using a cotton-price linked loan).

Commodity bonds are similar in scope, although here, the finance is provided by investors rather than a bank. While traditionally such bonds have been mostly used in oil and metals market, use in agricultural is possible (the first commodity bond was cotton-price-linked,